CSCO to Dominate Software-Defined Networks, Says Pac Crest

Pacific Crest‘s Brent Bracelin today reiterates an Outperform rating on shares of Cisco Systems (CSCO), which has been a relative bright spot amidst the broad market decline, currently up 2 cents at $20.85.

Bracelin thinks the stock can hit $25 in a year’s time, and further out could rise as high as $35, driven in part by greater focus on�software.

In particular, an evolution of Cisco with respect to software is already “well under way,” Bracelin thinks, and it marks in some ways a return to Cisco’s software roots in routing protocols, he thinks.

Bracelin focuses on the trend toward “software-defined networking,” or SDN, which some on the Street think could be a problem for Cisco. That theory holds that sophisticated software will allow enterprises and telecom firms to buy cheap switches instead of Cisco’s gear.

Not so, says Bracelin. SDN is a way for Cisco to increase the software content of its networking products:

Cisco has a long heritage in software and silicon as the leading architect of feature-rich routers and switches that have been instrumental in enabling Internet connectivity to 35% of the world�s population. The fact that Cisco has captured more than 50% of the switching and routing market, while generating a 15-year average gross margin of 65%, validates a long-term sustainable differentiation, largely because of its innovations in software and silicon. The recent advent of programmable software-defined networks (SDN) will not mark the demise of Cisco, in our view, but rather, drive the next leg of innovation at Cisco, enabling it to move further up the stack into software applications. The race is on for who will control the nascent, but fast-growing SDN application ecosystem. We think it will be Cisco, especially given the $7 billion investment it has already made on software and cloud M&A in the past 11 months. If successful, CSCO could evolve from a call on the improving macro and share gain into a call on a multiyear transition from a laggard to an innovator. Over the past decade, significant wealth has been created by technology stocks once viewed as laggards but became innovators. Only a few have made this transition�Apple, EMC, IBM, Oracle and SAP�and each created meaningful wealth over a multiyear period [...] Since the $1.2 billion Nicira acquisition by VMware, there has been rampant speculation that new software-defined networking (SDN) models could cannibalize Cisco�s core networking franchise [...] Based on the anticipated gradual pace of disruption as the industry shifts to programmable SDN architectures, Cisco has ample time to adjust its internal product roadmap while pursuing an offensive strategy to acquire and build the broadest portfolio of SDN applications before this market reaches critical mass. The value in a programmable post-SDN world will increasingly shift toward the SDN application layer, a new segment that we expect Cisco to dominate. Overtime, much like the hypervisor has commoditized within server virtualization, we view SDN controllers as the interface most at risk to commoditizing, with an increasing portion of the value extracted by SDN applications [...] We expect Cisco to pursue an aggressive build-andbuy strategy over the next two years, which eventually should expand Cisco�s reach. Within a pre-SDN world, Cisco bundled key software applications with internally developed equipment. This partially changes in a post-SDN world, where it will have the ability to sell Cisco-branded SDN applications on any vendor�s equipment.